Facultative vs. Treaty Reinsurance: An Overview
Facultative reinsurance and reinsurance treaties represent two common types of reinsurance contracts. Facultative reinsurance involves the primary insurer covering individual risks or a specific set of risks within its portfolio. On the other hand, treaty reinsurance entails an insurer purchasing insurance from another company. In facultative reinsurance, the reinsurer evaluates each insurance policy’s risks and can choose to accept or refuse them. In contrast, under a treaty reinsurance policy, the reinsurer typically assumes all risks associated with particular policies.
Key Takeaways
- Facultative and treaty reinsurance are both forms of reinsurance.
- Facultative reinsurance is tailored to single risks or defined risk packages.
- Facultative reinsurance involves individual underwriting for each policy.
- In treaty reinsurance, the ceding company passes on all risks to the reinsurer.
- Treaty reinsurance sees the reinsurer covering all risks without individual underwriting.
Investopedia / Alison Czinkota
Facultative Reinsurance
Facultative reinsurance offers a straightforward method for insurers to access reinsurance protection and can be tailored to specific situations with ease.
Facultative reinsurance involves reinsurers individually assessing and underwriting each policy to be reinsured. Each policy is treated as a separate transaction, allowing for customization based on risk. However, this can lead to ceding companies being left with the riskiest policies.
For instance, if an insurer writes a policy for a large commercial property for $35 million but can only afford to cover $25 million, it would seek facultative reinsurance to cover the remaining $10 million. Reinsurers may collectively cover this gap, enabling the issuance of the policy.
Treaty Reinsurance
Treaty reinsurance involves the ceding company transferring all risks within a specific insurance class to the reinsurer, which agrees to indemnify the ceding company for any related risks, even without individual underwriting. This arrangement may extend to future policies within the agreed class.
A key feature of treaty reinsurance is the absence of individual underwriting by the assuming company, shifting underwriting risks from the ceding company to the assuming company.
Treaties vary, with proportional treaties being common, where a percentage of policies are reinsured up to a limit, leaving excess policies uncovered by the treaty.
For instance, a reinsurance company may agree to cover 75% of an insurer’s automobile policies up to a limit, leaving the insurer accountable for the remainder. Premiums typically decrease as retention limits increase.
Special Considerations
Reinsurance companies offer coverage to traditional insurers to prevent financial shortfall in settling claims. The contracts shift risk from the reinsured to the reinsurer, allowing insurers to further diversify risk exposure.
Traditional insurance spreads the risk of loss among policyholders, paying premiums for protection against unforeseen events. However, when claims exceed premiums collected, insurers face potential losses. Reinsurance agreements help mitigate this risk.